Chapter 7

7-1
Income bonds do share some characteristics with preferred stock. The primary difference
is that interest paid on income bonds is tax deductible while preferred dividends are not.
Income bondholders also have prior claims on the assets, if the firm goes bankrupt. In
calculating cost of capital, the primary difference will be that income bonds can be
treated as debt (because they provide the tax advantage) and preferred stock cannot.

7-2
Commodity bonds are different from straight bonds because the interest payments on
these bonds are not fixed but vary with the price of the commodity to which they are
linked. There is more risk, therefore, to the holder of these bonds.
It is different from equity since the cash flows are constrained. Even if the commodity's
price does go up, the payments on the commodity bond will go up only by the defined
amount, whereas equity investors have no upside limit. Commodity bondholders also
have prior claims on the assets of the firm if the firm goes bankrupt.
I would treat commodity bonds as debt, but recognize that it is also debt that creates less
bankruptcy risk if the firm gets into trouble due to commodity price movements.

7-3
The first characteristic - a fixed dividend and a fixed life - is a characteristic of debt, as is
the last one - no voting rights. The other two - no tax deductions and secondary claims on
the assets - make it more like equity. In fact, this security looks a lot like preferred stock,
and I would treat it as such.

7-4
Value of Straight Preferred Stock portion of Convertible = 6/.09 = $66.67 !
Preferred stock has perpetual life, and the coupons are set forever.
I am valuing the preferred stock portion, using the preferred dividend rate on straight
preferred.
Value of Conversion Portion = $105 - $66.67 = $38.33

7-5
The convertible bond is a 10-year bond with a face value of $1000 and a coupon rate of
5%. If it yielded the same rate as the straight bond, i.e. 8%, its price would be equal to
25 1 1000
(1 − 20
)+ = 796.15 , assuming semi-annual coupons. Hence, the equity
.04 1.04 1.04 20
component of the convertible can be estimated as 1100 - 796.15 = 303.85.

The total equity component of the firm’s asset value = 50(1 m.) + 303.85(20000) =
$56.077m.
The debt component = $25m. + 796.15(20000) = 40.923m.
Hence, the debt ratio = 40.923/(40.923 + 56.077) = 42.19%

7-6
Value of Equity = 50,000 * $100 + 100,000 * $90 = $14,000,000
Value of Debt = $5 million
Debt Ratio = 5/(5+14) = 26.32%
Since the debt was taken on recently, it is assumed that the book value of debt is equal to
market value.

7-7
a. The cost of internal equity = 6.5 + 1.2(6) = 14.3%
b. The cost of external equity = (100/95)(14.3) = 15.0526%
(In effect, we get to keep only $95 out of every $100 raised, which raises the cost of
equity)

7-8
a. If the current owners give up 30% of the firm, they will be left with (0.7)(120) = $84m.
Otherwise, they have $80m. Hence, they are better off taking the venture capital,
assuming that they cannot raise financing on better terms.
b. The breakeven percentage would be x, where x solves 120x = 80, or x = 2/3; i.e. the
owners should be willing to give up no more than 33% of the firm.
(I am assuming that the $120 million in new firm value is inclusive of the cash raised
from the venture capitalist as well)

7-9
We assume that Office Helpers is choosing to go public instead of using venture capital.
Furthermore, we assume that the market valuation of $120 will hold even with the IPO.
Finally, let us assume that $20 million need to be raised. Now, if the target price is $10,
which represents an under pricing of 20%, the true value of the shares would be 10/.8 =
$12.5 per share. At this price, the firm would have to issue 20/10 or 2 million shares.
Since the 2 million shares will represent a value of $25 million, the total number of
shares outstanding would be 2(120/25) = 9.6 million shares. Of this, the existing
shareholders would get 7.6 million shares, representing a value of (7.6/9.6)120 = $95m.;
the public shareholders would get (2/9.6)120 = $25m. for which they would have paid
2(10) = $20m., or an undervaluation of 5/25 or 20%.

7-10
a. The exit value will be 50(15) = $750m.
b. The discounted terminal value is 750/1.354 = $225.80m.
c. You would ask for at least 75/225.80 or 33% of the firm.
(I am computing the value, prior to the cash infusion. The owner will probably come
back with a counter offering you 75/(225.80+75), which is the post money value)

7-11
a. The expected return using the CAPM is 6.5 + 1.1(6) = 13.1%
b. Venture capitalists typically have to invest a large portion of their portfolio in a single
firm; hence there is a lot of diversifiable risk that they would have to hold.
There is a second concern that may not be reflected in betas and the expected return. A
large number of young firms fail, and your expected return has to be increased to cover
this failure risk.

7-12
The loss to the existing shareholders is 50($18) = $900m.
The main people gaining from the under pricing are the investors that are able to buy the
stock at the issue price and the investment bankers who get paid their underwriting fees,
while bearing little risk.

7-13
I am in qualified agreement with this statement. It is true that IPOs are more difficult to
value, partially because they tend to be younger firms and partially because you don’t
have an anchor of a market assessed value.
I would test it empirically by looking at the extent of underpricing for firms at different
stages in the life cycle. If this statement is true, I would expect the underpricing to be
greatest in younger, more difficult to value firms.
In a rational market, though, this should offer an opportunity for investors who can get
into these stocks at the offering price.

7-14
a. Since you are a small firm, you should consider the reputation of the investment
banker. A more reputable investment banker may be able to attract wary investors into
the offering. If you are a high technology or biotechnology firm, where technical
knowledge may be essential in the valuation process, you should pick an investment
banker with some experience with similar issues.

b. If the issue is fairly priced, 40% of the firm (20/50). If the valuation was done, prior to
the considering the cash infusion from the IPO, it would be lower (20/(50+20))

c. If the investment banker underprices the issue, you will have to sell
Value of Securities Sold = $20/.9 = $22.22
As % of Overall Firm Value = 22.22/50 = 44.44%

d. You would have to create roughly 2 million shares: ($50 million/2 million = $25). You
would then need to issue about 800,000 shares to raise $20 million.

7-15
a.
Number of shares you would need to sell in rights offering = $100 mil/$25 = 4 million
Number of shares outstanding = 10 million; Number of rights = 10 million
You would need 5 rights to buy two shares.

b. Ex-rights price = (50*10+25*4)/14 = $42.86

c. Value per right = Pre-rights price - Ex-rights price = $50 - $42.86 = $7.14

d. If the price of the right were higher than $7.14, I would sell my rights at the higher
price and keep the difference as excess return. The stock price after the rights issue and
the cash will yield me more than what I paid for the stock, which was $50.

7-16
a. Expected Stock Price = (1 million * $15 + 500,000 * $10)/1.5 million = $13.33

b. Price per Right = $15 - $13.33 = $1.67

c. No, because I will own more shares after the issue.

7-17
a. The current capital is $15(1 million shares) = $15million. Additional capital to be
raised is $10(0.5 million shares) = $5 million. Hence, net income after the issue will be
$1 million(20/15) = $1.33 million. Hence EPS would be 1.33/1.5 = 88.67 cents per
share.
b. Earnings per share under this alternate scenario would be 1.33/1.33 = $1 per share
c. No, if I have availed myself of the rights issue; in this case, I would have more shares
and the same proportional ownership of the firm. Even if I had sold the right, I would
have been compensated for the lost value.

7-18
a. Annual tax savings from debt = $ 40 million * .09 * .35 = $1.26 million

b. PV of Savings assuming savings are permanent = $40 million * .35 = $14.00

(You can get there by dividing your annual tax savings, $1.26 million, by the pre-tax cost
of debt of 9%)

c. PV of Savings assuming savings occur for 10 years = $1.26 (PVA,9%,10) = $8.09

d. PV of Savings will increase

If savings are permanent = 1.26/.07 = $18.00
If savings are for 10 years = $1.26 (PVA,7%,10) = $8.85
(I am assuming that your interest expenses are locked in. If you can refinance the debt at
the lower rate, the answer will be different)

7-19
a. After-tax interest rate = 10% (1-.45) = 5.50%

b. If only half the interest is allowed = 10% (1-.225) = 7.75%

c. Yes. The tax savings will be much lower since the tax savings will not occur until three
years from now. The after-tax interest rate will therefore be the same as the pre-tax rate
(10%) for the first three years. Put another way, the tax savings from interest expenses
will have to be discounted back three years.

7-20
a. Ignoring the net operating loss,
PV of Tax Savings = $5 billion (.36) = $1.8 billion

b. Yes. The net operating loss will mean that this tax savings will not occur for a while.
For instance, if it will be 5 years before Westinghouse will have enough taxable income
to claim the interest deduction, this $ 1.8 billion should be discounted back 5 years to
arrive at the present value.

7-21
a. False. There may be non-discretionary capital expenditures/working capital needs that
drain cash flows.

b. False. Depreciation may also be large and offset the cap ex.

c. Partially true. The commitment to pay dividends is a much weaker one than the one to
pay interest expenses.

d. False. It is precisely when managers are not owners that they may need the discipline
of debt.

e. False. Not necessarily. Mature, well run firms can have high free cash flows.

7-22
While there may be other motives behind acquisitions, the firm that would look most
promising on the free cash flow hypothesis would be the firm with low growth, poor
projects, low leverage and good earnings. It is in this firm that the discipline of
borrowing money will have the greatest impact in terms of inducing managers to pick
better investments.

7-23
a. Cost of Equity = 9% + 6% = 15%
Since it is an all-equity financed firm, the cost of capital is equal to the cost of equity.

b.
Marginal Marginal
Value of Debt Increase in Debt Tax Benefits Exp. Bankruptcy Cost
2500,000 2,500,000 1,000,000 0
5000,000 2,500,000 1,000,000 640,000
7500,000 2,500,000 1,000,000 1,000,000
8000,000 500,000 200,000 760,000
9000,000 1000,000 400,000 1,200,000
10,000,000 1000,000 400,000 600,000
12,500,000 2,500,000 1,000,000 1,400,000

Every marginal increment past $7.5 million has expected cost > expected tax benefits!
Optimal debt is between $ 5 million and $ 7.5 million.

c. Value of Firm at Optimal Capital Structure = Current Firm Value + Sum of Marginal
Tax Benefits - Sum of marginal bankruptcy costs = $13,360,000

7-24

Depends on which version of the Miller Modigiliani world you devise. In the original
version, with no bankruptcy costs and taxes, here is the answer:

a. In the Miller-Modigliani world with no taxes and default risk, the value of the firm will
be $ 100 million no matter what the debt ratio.

b. The cost of capital will always be 11%.

c. With taxes, the value of the firm will increase as the debt is increased (because of the
tax benefits of debt) and the cost of capital will go down (due to the interest tax savings
again).

7-25
Of $1 paid to bondholders from corporate before-tax income, the bondholder gets (1-0.4)
= 60 cents. Of the same dollar paid to equity holders, the equity holder gets (1-0.3)(1-
0.2) = 56 cents. Hence debt does have a tax advantage.
If a firm with no debt and a market value of $100 million borrowed $50 million in this
world, it would obtain a benefit of 1-0.56/0.6 = 1/16 of the amount issued, or 50/16 =
$3.33 million. Hence the firm value would be 100 + 50 + 3 = $153 million.

7-26
The tax rate on equity would have to be t, where t solves (1-0.3)(1-t) = 1-0.4, i.e. 1-t = (1-
0.4)/(1-0.3) = t = 14.286%

7-27
a. The past policy of not using debt can be justified by noting that returns on projects
were high (increasing the need for flexibility) and that earnings in the future were likely
to be volatile (because of the growth).

b. Given that returns on projects are declining, I would argue for a greater use for debt.

7-28
a. Financial flexibility is higher with low leverage in several ways: one, the firm can use
retained earnings for whatever purposes it chooses: it is not forced to pay out funds as
debt service. Also, with low leverage and high debt capacity, the firm can tap into this
debt capacity if funds are urgently needed. Finally, there are likely to be fewer covenants
to restrict the firm.
b. The tradeoff is flexibility versus the tax advantages of debt and the discipline enforced
by debt on wayward managers.

7-29
a. An electric utility is regulated (reducing agency costs), has stable and predictable cash
flows (reducing bankruptcy needs), and knows its future investment needs with some
precision (reducing the need for flexibility). All of these factors will increase its capacity
to carry debt.

b. Yes. Both the regulation and the monopoly characteristics reduce the agency costs and
bankruptcy costs, increasing debt capacity.